UNIFORM LAW COMMISSIONERS MANAGEMENT OF PUBLIC EMPLOYEE PENSION FUNDS ACT UNIFORM LAW COMMISSIONERS MANAGEMENT OF PUBLIC EMPLOYEE PENSION FUNDS ACT

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1 D R A F T FOR DISCUSSION ONLY UNIFORM LAW COMMISSIONERS MANAGEMENT OF PUBLIC EMPLOYEE PENSION FUNDS ACT NATIONAL CONFERENCE OF COMMISSIONERS ON UNIFORM STATE LAWS MEETING IN ITS ONE-HUNDRED-AND-FIFTH YEAR SAN ANTONIO, TEXAS JULY 12 - JULY 19, 1996 UNIFORM LAW COMMISSIONERS MANAGEMENT OF PUBLIC EMPLOYEE PENSION FUNDS ACT WITH PREFATORY NOTE AND COMMENTS Copyright 1996 By NATIONAL CONFERENCE OF COMMISSIONERS ON UNIFORM STATE LAWS The ideas and conclusions herein set forth, including drafts of proposed legislation, have not been passed on by the National Conference of Commissioners on Uniform State Laws. They do not necessarily reflect the views of the Committee, Reporters or Commissioners. Proposed statutory language, if any, may not be used to ascertain legislative meaning of any promulgated final law.

2 DRAFTING COMMITTEE ON MANAGEMENT OF PUBLIC EMPLOYEE PENSION FUNDS ACT DWIGHT A. HAMILTON, Suite 600, 1600 Broadway, Denver, CO 80202, Chair JERRY L. BASSETT, Legislative Reference Service, 613 Alabama State House, 11 South Union Street, Montgomery, AL THOMAS S. LINTON, 4323 Shorebrook Drive, Columbia, SC RICHARD B. LONG, P.O. Box 2039, One Marine Midland Plaza, Binghamton, NY EDWARD F. LOWRY, JR., Suite 1120, 2901 North Central Avenue, Phoenix, AZ DAVID T. PROSSER, JR., P.O. Box 8953, Room 211 West, State Capitol, Madison, WI MILLARD H. RUUD, University of Texas, School of Law, 727 East 26th Street, Austin, TX W. STEPHEN WILBORN, Suite 403, 305 Ann Street, Frankfort, KY STEVEN L. WILLBORN, University of Nebraska, College of Law, Lincoln, NE 68583, Reporter EX OFFICIO BION M. GREGORY, Office of Legislative Counsel, State Capitol, Suite 3021, Sacramento, CA , President JOHN H. LANGBEIN, Yale Law School, P.O. Box , New Haven, CT 06520, Chair, Division D EXECUTIVE DIRECTOR FRED H. MILLER, University of Oklahoma, College of Law, 300 Timberdell Road, Norman, OK 73019, Executive Director WILLIAM J. PIERCE, 1505 Roxbury Road, Ann Arbor, MI 48104, Executive Director Emeritus Copies of this Act may be obtained from: NATIONAL CONFERENCE OF COMMISSIONERS ON UNIFORM STATE LAWS 676 St. Clair Street, Suite 1700 Chicago, Illinois /

3 UNIFORM LAW COMMISSIONERS MANAGEMENT OF PUBLIC EMPLOYEE PENSION FUNDS ACT TABLE OF CONTENTS SECTION 1. DEFINITIONS... 5 SECTION 2. SCOPE SECTION 3. ESTABLISHMENT OF TRUST SECTION 4. POWERS OF TRUSTEE SECTION 5. DELEGATION OF FUNCTIONS SECTION 6. GENERAL DUTIES OF TRUSTEE AND FIDUCIARY SECTION 7. DUTIES OF TRUSTEE IN INVESTING AND MANAGING ASSETS OF RETIREMENT SYSTEM SECTION 8. APPLICATION OF TRUSTEE AND FIDUCIARY DUTIES SECTION 9. LIABILITY OF TRUSTEE OR FIDUCIARY SECTION 10. [OPEN OR PUBLIC] RECORDS AND MEETINGS SECTION 11. DISCLOSURE TO PUBLIC SECTION 12. DISCLOSURE TO PARTICIPANTS AND BENEFICIARIES SECTION 13. REPORTS TO [AGENCY] SECTION 14. SUMMARY PLAN DESCRIPTION SECTION 15. ANNUAL DISCLOSURE OF FINANCIAL AND ACTUARIAL STATUS SECTION 16. FINANCIAL STATEMENT SECTION 17. OPINION ON FINANCIAL STATEMENT SECTION 18. ACTUARIAL STATEMENT FOR DEFINED BENEFIT PLANS SECTION 19. OPINION ON ACTUARIAL STATEMENT FOR DEFINED BENEFIT PLANS SECTION 20. STATEMENT CONCERNING GUARANTEED BENEFITS SECTION 21. ENFORCEMENT SECTION 22. ALIENATION OF BENEFITS [SECTION 23. PURCHASE OF SERVICE CREDIT] SECTION 24. UNIFORMITY OF APPLICATION AND CONSTRUCTION SECTION 25. SHORT TITLE SECTION 26. SEVERABILITY SECTION 27. EFFECTIVE DATE SECTION 28. REPEALS SECTION 29. SAVINGS AND TRANSITIONAL PROVISIONS

4 UNIFORM LAW COMMISSIONERS MANAGEMENT OF PUBLIC EMPLOYEE PENSION FUNDS ACT PREFATORY NOTE State and local retirement systems currently manage in excess of $1 trillion in assets for the benefit of participants and beneficiaries. The well-known federal law regulating the management of retirement funds, the Employee Retirement Income Security Act (ERISA), does not apply to these systems. ERISA 3(32), 4(b), 29 U.S.C. 1002(32), 1003(b) (1994). Instead, the systems are regulated by law in each State. That law varies considerably across States and has often failed to keep pace with modern investment practices. The Management of Public Employee Pension Funds Act (MPEPFA) will modernize, clarify, and make uniform the rules governing the management of public retirement systems. Statement of the History of the Act In January, 1991, the Scope and Program Committee of the National Conference recommended the appointment of a Study Committee to examine the feasibility of a project on the management of public employee pension funds. In February, 1991, the Executive Committee appointed a Study Committee. In December, 1992, the Study Committee recommended that a Drafting Committee be appointed. The Scope and Program Committee accepted the Study Committee's determination that such a project would be meritorious, but deferred its approval until other interested parties could be consulted. In mid-1994, after the Study Committee reported on additional consultations, the Scope and Program Committee recommended that a Drafting Committee be formed, and the Executive Committee concurred. The Drafting Committee has met three times since it was created, and this is the third draft of the Act. The Committee on Style has reviewed this draft and one prior draft. Summary of the Contents of the Act In broad terms, the Act protects participants and beneficiaries of public retirement systems in two ways. First, the Act articulates the fiduciary obligations of trustees and others with discretionary authority over various aspects of a retirement system, and ensures that trustees have sufficient authority to fulfill those obligations (Sections 3 through 9). Second, the Act facilitates effective monitoring of retirement systems by requiring regular and significant disclosure of the financial and actuarial status of the system, both to participants and beneficiaries directly, and to the public (Sections 10 through 20). Considered in more detail, the Act's regulation of the management of public employee pension funds can be divided into seven general categories. First, the Act requires that all retirement system assets be held in trust (Section 3). Second, the Act ensures that the trustee has exclusive authority over those assets (Section 3) and 1

5 sufficient control over the enterprise to manage the assets efficiently and effectively (Sections 4 and 5). Third, the Act articulates the duties of trustees and others with discretionary authority over the operation and administration of a retirement system or the management of its assets (Sections 5 through 8). Fourth, to facilitate effective monitoring of retirement systems, the Act imposes significant disclosure requirements. The Act clarifies the application of state open record and open meetings laws to retirement systems (Section 10) and requires systems to publish various types of reports (Sections 11 through 20). The reports must be distributed widely and made available to the public (Sections 11 through 13). Fifth, the Act has provisions to permit effective enforcement (Sections 9 and 21). Sixth, the Act prohibits the assignment or alienation of benefits, unless the legislature specifically decides that assignment or alienation is appropriate and consistent with the underlying policy of protecting retirement benefits (Section 22). Finally, the Act contains bracketed language providing for the purchase of service credit (Section 23). Reasons for National Conference Consideration Since the late 1960's, the investment practices of fiduciaries experienced significant change. These changes occurred under the influence of a large and broadly accepted body of empirical and theoretical knowledge about the behavior of capital markets, often described as "modern portfolio theory." The law of trust investment has been modernized to keep pace with these changes, and the National Conference has actively participated in the effort. Restatement (Third) of Trusts: Prudent Investor Rule (1992) (hereinafter "Restatement of Trusts 3d: Prudent Investor Rule"); Uniform Prudent Investor Act, 7B U.L.A. 16 (Supp. 1995) (hereinafter "Uniform Prudent Investor Act"); Uniform Principal and Income Act, 7B U.L.A. 145, 183 (1931, 1962) (revisions to Act under consideration by the Conference). A primary purpose of this Act is to facilitate the incorporation of these modern investment practices into state law regulating the management of public employee pension funds. The Act is designed to replace laws that inhibit or, in a number of States, even prevent use of modern investment practices. In the long run, these outmoded laws result in billions of dollars of lost opportunities for investment income. The lost income could be used to increase pension benefits, lower contribution rates, or some combination. The immediate beneficiaries would be the system's participants and beneficiaries, but the ultimate beneficiary would be the State's taxpayers. Taxpayers could offer employees either a better pension for the same cost, or the same pension for a lower cost. Investment returns, in essence, permit the State to export a portion of the cost of operating a pension system. And, obviously, the more that is exported, the less taxpayers (and participants) have to contribute. The Act facilitates the incorporation of modern investment practices, in large part, by revising and clarifying the standards of prudent retirement fund investing. Five general areas are affected. All are found in the Restatement of Trusts 3d: Prudent Investor Rule and all derive from the Uniform Prudent Investor Act, another National Conference initiative to incorporate modern investment practices into state law: 2

6 (1) The standard of prudence is applied to any investment as part of the total portfolio, rather than to individual investments. In the retirement system setting, the term portfolio embraces the assets of each retirement program or appropriate group of programs. MPEPFA 8(b). (2) The tradeoff in all investing between risk and return is identified as the trustee's central consideration. MPEPFA 8(b). (3) All categoric restrictions on types of investments have been abrogated; the trustee can invest in anything that plays an appropriate role in achieving the risk/return objectives of the program and that meets the other requirements of prudent investing. MPEPFA 7(g). (4) The long familiar requirement that trustees diversify their investments has been integrated into the definition of prudent investing. MPEPFA 7(c). (5) The power of a trustee to delegate investment and management functions is affirmed, clarified, and subjected to safeguards. MPEPFA 5. [Portions of the preceding three paragraphs were drawn from Comments to the Prudent Investor Act.] These standards of prudent investing apply to retirement system trustees. Consequently, they can only be effective in incorporating modern investment practices into the retirement system setting to the extent trustees have the independence and institutional resources necessary to comply. The Act contains provisions that protect the ability of trustees to manage retirement system assets in accordance with the prudency standards of this Act and, hence, in accordance with modern investment practices. MPEPFA 3-5. At the same time, the Act facilitates effective monitoring of trustees by requiring significant openness in the operation of retirement systems. MPEPFA Although modernization is the principal goal, this Act also furthers other National Conference objectives. Uniform fiduciary rules should expand the pool of investment managers available to retirement systems. Out-of-state investment managers would no longer have to worry about unusual or unique fiduciary rules that might be contained in state law and, thus, should be more willing to provide their services. This would enhance the efficiency of the market in investment services and facilitate the flow of those services across state lines. Similarly, even under current law, retirement systems often contract with out-of-state investment managers. If a dispute arises over compliance with fiduciary obligations, enactment of this Act in both relevant States would avoid any conflict of laws questions. Finally, recent experience has reaffirmed the interstate implications of fiduciary problems. Bond Markets are Roiled by [Orange County] California Bankruptcy Filing, N.Y. Times, December 8, In the modern financial marketplace, the fiduciary obligations of those acting on behalf of retirement systems are never of purely local or state concern. 3

7 UNIFORM LAW COMMISSIONERS' MANAGEMENT OF PUBLIC EMPLOYEE PENSION FUNDS ACT SECTION 1. DEFINITIONS. In this [Act]: (1) "Acceptable actuarial cost method" means a recognized actuarial method used to determine the present value of the benefits and expenses of a retirement program and to develop an allocation of the value to periods of time. The term includes the aggregate, attained age, entry age normal, frozen attained age, frozen entry age, and unit credit actuarial cost methods, but not the terminal funding or current funding cost method. (2) "Actuarial accrued liability" means that portion of the present value of the benefits and expenses of a retirement program which is not provided for by the annual cost of future retirement program benefits and expenses assigned to years following the date of the actuarial valuation as determined by an acceptable actuarial cost method or, for retirement systems using the aggregate actuarial cost method, as determined by an actuarial cost method other than the aggregate actuarial cost method that, in the actuary's opinion, provides an accurate report of the program's actuarial status. (3) "Actuarial value of assets of the system" means the fair value of the assets of a retirement system adjusted, as necessary and appropriate, to diminish the effects of short-term volatility. (4) "Administrator" means an individual primarily responsible for the operation and administration of a retirement system or, if an individual is not clearly designated, the trustee of the system who has the ultimate authority to operate and administer the system. 4

8 (5) "Agent group of programs" means a group of retirement programs which shares administrative and investment functions but maintains separate accounts for each retirement program so that assets accumulated for a particular program may be used to pay benefits only for that program's participants and beneficiaries. (6) "Annual compensation" means the portion of an employee's total earnings from a public employer during a fiscal year on which contributions to a retirement program are based, as determined by the retirement system. (7) "Appropriate group of programs" means: (i) for defined benefit plans, a cost-sharing group of programs or an agent group of programs; and (ii) for defined contribution plans, a group of retirement programs that shares administrative and investment functions. (8) "Beneficiary" means a person designated by a participant or by a retirement program to receive a benefit under a program. The term does not include a participant. (9) "Code" means the federal Internal Revenue Code of 1986, as amended. (10) "Cost-sharing group of programs" means a group of retirement programs in which all assets accumulated for the payment of benefits may be used to pay benefits to participants and beneficiaries of any program in the group. (11) "Defined benefit plan" means a retirement program other than a defined contribution plan. (12) "Defined contribution plan" means a retirement program that provides for an individual account for each participant and for benefits based solely upon the amount contributed to the participant's account, and any income, expenses, gains, 5

9 and losses, and any forfeitures of accounts of other participants which may be allocated to the participant's account. (13) "Employee" means an employee or officer of a public employer. (14) "Fair value" means the amount that a willing buyer would pay a willing seller for an asset in a current sale, as determined in good faith by a fiduciary. (15) "Fiduciary" means a person who exercises any discretionary authority to manage the operation and administration of a retirement system or any authority to invest or manage assets of the system, or who renders investment advice for a fee or other direct or indirect compensation with respect to assets of the system, or has any authority or responsibility to do so. (16) "Furnish" means to deliver personally, to mail to the last known place of employment or home address of the intended recipient or, if reasonable grounds exist to believe that the public employer will make a good faith effort to deliver personally or by mail, to provide to the intended recipient's employer. (17) "Governing law" means state and local laws establishing or authorizing the creation of a retirement program or system and the principal state and local laws and regulations governing the operation, administration, or management of the assets of a program or system. (18) "Guaranteed benefit policy" means an insurance policy or contract to the extent the policy or contract provides for benefits in a guaranteed amount. The term includes any surplus in a separate account, but excludes any other portion of a separate account. (19) "Insurer" means an insurance company, insurance service, or insurance organization qualified to do business in this State. 6

10 (20) "Nonforfeitable" means an immediate or deferred benefit that arises from a participant's service, is unconditional, and is enforceable against the retirement system. (21) "Participant" means an individual who is or has been an employee enrolled in a retirement program and who is or may become eligible to receive a benefit under the program, or whose beneficiaries are or may become eligible to receive a benefit. The term does not include an individual who is no longer an employee of an employer and has not accrued any nonforfeitable benefits under that employer's retirement program. (22) "Present value", with respect to a liability, means the value actuarially adjusted to reflect anticipated events. (23) "Public employer" means this State or any political subdivision, or any agency or instrumentality of this State or any political subdivision, whose employees are participants in a retirement program. (24) "Qualified public accountant" means: (i) an audit agency of this State or of a political subdivision of this State which has no direct relationship with the functions or activities of the retirement system or its fiduciaries other than functions relating to this [Act]; or (ii) a person who is a certified public accountant, certified or licensed by a regulatory authority of a State. (25) "Related person" of an individual means: (i) the individual's spouse, or parent or sibling of the spouse; (ii) the individual's child, grandchild, sibling, or parent, or spouse of the individual's child, grandchild, sibling, or parent; (iii) another individual having the same home as the individual; 7

11 (iv) a trust or estate of which an individual described in subparagraph (i), (ii), or (iii) is a substantial beneficiary; or a fiduciary. (v) a trust, estate, incompetent, ward, or minor of which the individual is (26) "Retirement program" means a program of rights and obligations established or maintained for its employees by a public employer to the extent that, by its express terms or as a result of surrounding circumstances, the program, regardless of the method of calculating the contributions made to the program or the benefits under the program, or the method of distributing benefits from the program: (i) provides retirement income to employees; or (ii) results in a deferral of income by employees for periods extending to the termination of covered employment or beyond. (27) "Retirement system" means an entity established or maintained to operate or administer, or to invest or manage the assets, of one or more retirement programs. [May list state retirement systems and statutes authorizing the formation of systems.] (28) "Trustee" means a person who has ultimate authority to manage the operation and administration, or to invest or manage the assets, of a retirement system. Reporter's Notes/Comment Paragraphs (1)-(3) define actuarial terms. With one exception, the definitions are well-known and commonly accepted in the actuarial profession. Measuring Pension Obligations, Actuarial Standard of Practice No. 4, app. II(A) (Actuarial Standards Board 1993); Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans, Statement of Governmental Accounting Standards No. 25, 45 (Governmental Accounting Standards Board 1994) (hereinafter "GASB Standard No. 25"). The one exception is that the definition of "actuarial accrued liability" in paragraph (2) requires retirement systems using the aggregate actuarial cost method 8

12 to determine the actuarial accrued liability using a different actuarial cost method. The aggregate method does not identify or separately amortize unfunded actuarial liabilities. As a result, the method cannot be used to produce the types of important disclosures that this Act requires in Section 18(b)(4)(iii)-(vi) (requiring disclosure of four measures of funding status that depend on identification of actuarial accrued liability). Given this limitation of the aggregate actuarial cost method, two general options are available: 1) to exempt systems using the aggregate method from these disclosure requirements or 2) to require systems to produce the required information using another actuarial cost method. The Governmental Accounting Standards Board has opted for the first approach. GASB Standard No. 25, 33 n. 17. The Drafting Committee has opted for the second approach for a number of reasons. First, the types of information on funding status required by Section 18 are crucially important to those interested in monitoring funding progress. Second, the average participant and beneficiary will be able to understand the type of information required by Section 18, but are quite unlikely to be able to decipher the type of information the aggregate method produces on funding progress. Third, the aggregate method is currently used by only a small minority of retirement systems. Paul Zorn, Survey of State and Local Government Employee Retirement Systems B-32 (The Public Pension Coordinating Council 1994) (26 of 451 retirement systems responding to the survey reported using the aggregate actuarial cost method). Thus, requiring systems to produce the information required by this Act by using a method other than the aggregate method should not create a great deal of disruption or impose unacceptable costs. This is especially the case since some systems using the aggregate method already produce this type of information, see New York State Teachers' Retirement System, Comprehensive Annual Financial Report 31 (1995), and because the definition does not require the information to be produced by an "acceptable actuarial cost method," but only by a method that will, in the actuary's opinion, provide an accurate report of the system's funding status. Fourth, requiring retirement systems to produce the information required by this Act by using an alternative actuarial cost method does not conflict with the approach of the Governmental Accounting Standards Board. GASB Standard No. 25, 124 (retirement systems using the aggregate method may use another method to present information on funding progress). The definition of "agent group of programs" in paragraph (5), together with the definitions of "appropriate group of programs" in paragraph (7) and "costsharing group of programs" in paragraph (10), support the fiduciary requirements of Section 7 and the reporting and disclosure requirements of Sections and In evaluating fiduciary responsibilities and reporting obligations, the default rule is that the focus should be on each individual retirement program. A trustee, for example, should diversify the investments of each program, MPEPFA 7(c), and the annual disclosure of financial and actuarial status should describe the actuarial position of each program. MPEPFA 15(b). Some retirement programs, however, are so interconnected that the focus appropriately should be on the group of programs. These definitions are used later in the Act to delineate when the default focus on individual programs is overridden, and the focus should fall instead on a group of programs. The definitions track those established in GASB Standard No. 25, 15-16, 44, and, hence, are well understood in the actuarial community. 9

13 The last sentence of the definition of "beneficiary" in paragraph (8) creates a distinction between participants and beneficiaries. In essence, a participant expects benefits based on her own service, while a beneficiary expects benefits based on someone else's service. The last sentence does not, however, preclude the possibility that someone can, at the same time, be both a participant based on her own service and a beneficiary based on someone else's service. Paragraph (9) refers to the federal Internal Revenue Code of State and local retirement programs have varied and complex relationships to the Code, and the Act makes reference to it at several points. The National Conference recognizes that in some States this may give rise to problems of delegation of legislative power. However, given the complex relationship between many state laws and the Code, references of this type are increasingly common and have been sustained. See, e.g., McFaddin v. Jackson, 738 S.W.2d 176 (Tenn. 1987); Thorpe v. Mahin, 250 N.W.2d 633 (Ill. 1969); City National Bank of Clinton v. Iowa State Tax Commission, 102 N.W.2d 381 (1960). In any event, whatever difficulties may be involved, the course adopted in this Act seems preferable to the alternative of restating federal tax law in the Act, continually monitoring that law for relevant changes, and repeatedly amending the Act in response to changes. [This Comment follows a Comment in ULC's Consumer Credit Code, Prefatory Note, 7A U.L.A. 1, (1974).] The definition of fiduciary in paragraph (15) is derived from ERISA 3(21), 29 U.S.C. 1002(21) (1994), and is intended to incorporate ERISA's general, discretion-sensitive conceptions of fiduciary status into the Act. The definition of "furnish" in paragraph (16) is intended to require that information be made readily available to the intended recipient, but is not intended to limit the technology used to make the delivery. The terms "deliver personally" and "mail" are intended to be interpreted broadly to permit conveyance of information through a wide variety of modern technologies, such as by fax or electronic delivery. The definition of public employer in paragraph (23) tracks the definition of "governmental plan" in Section 3(32) of ERISA. 29 U.S.C. 1002(32) (1994). See also, I.R.C. 414(d) (1994) (same definition of "governmental plan" also used in the Code). ERISA is broadly preemptive of state law, but it does not cover governmental plans. ERISA 4(b)(1), 514, 29 U.S.C. 1003(b)(1), 1144 (1994). The Drafting Committee considered drafting language to include various types of state employers more specifically, for example, municipal corporations, public school district, and public hospital organizations. Instead, however, the Drafting Committee decided to track the ERISA language to make it clear that the definition is intended to reach all state employers that fall within ERISA's exemption for governmental plans. Thus, even though the definition does not specifically mention various types of state employers, the intent is to be broadly inclusive. The definition of related person in paragraph (25) supports the disclosure requirement of Section 16(b)(7). The definition tracks very closely the definition of the same term in the Model Business Corp. Act 8.60(3) (1995). The Model Business Corp. Act's definition of "related person" is currently in the statutes of nine States. 10

14 The definition of trustee in paragraph (28), by necessity, must cover a wide range of institutional arrangements for the allocation of ultimate authority over retirement systems. Some retirement systems have one set of trustees with ultimate authority over all aspects of the system. Other systems have more than one set of trustees, with each set having ultimate authority over a particular aspect of the system. The definition of trustee is intended to cover every individual who has ultimate authority over any aspect of a retirement system. Later sections of the Act using the term "trustee" may refer to all trustees or to only some trustees, depending on context and the institutional arrangements of the particular retirement system. For example, as a general matter, all trustees may delegate functions under Section 5, but only trustees who invest and manage retirement system assets are subject to the duties of Section 7. Partly because of the diversity of institutional arrangements, the Drafting Committee decided not to include in the Act any rules for the selection or composition of boards of trustees. Although the consensus opinion of the Drafting Committee was that stakeholders (including especially employees, participants, and beneficiaries) should be represented on governing boards, the view also was that these issues should be left to the discretion of individual States. Since States may differ legitimately on a number of issues relating to board selection and composition (such as the size of trustee boards, what stakeholder groups merit representation, the proportion of representation each group should have, who is entitled to select each stakeholder's representative, etc.), a uniform rule was thought undesirable. At the same time, however, it should be noted that the Act does not leave completely unattended the interests that fuel concern about stakeholder representation on trustee boards; regardless of how they are selected or who they represent, the Act requires trustees to act solely in the interest of participants and beneficiaries. MPEPFA, 6(1). SECTION 2. SCOPE. This [Act] applies to all retirement programs and systems established or maintained on behalf of employees by public employers, except: (1) a retirement program that is unfunded and is maintained by a public employer solely for the purpose of providing deferred compensation for a select group of management employees or employees who rank in the top five percent of employees of that employer based on compensation; (2) a severance pay arrangement pursuant to which payments are made solely on account of the termination of an employee's service and are not contingent upon the employee's retiring; the total amount of the payments does not exceed the equivalent of twice the employee's total earnings from the public employer during 11

15 the year immediately preceding the termination of service; and all payments are completed within 24 months after the termination of service; (3) a supplemental retirement income arrangement pursuant to which payments are made solely to supplement the benefits of retired participants or their beneficiaries to account for some portion or all of the increases in the cost of living since retirement; the public employer is not obligated to make the payments pursuant to the retirement program providing the basic benefits; and payments are made out of the general revenues of the employer, out of a separate trust fund established and maintained solely for that purpose, or out of a special appropriation received by the employer for that purpose; (4) an arrangement or payment made on behalf of an employee because the employee is covered by Title II of the Social Security Act, as amended (42 U.S.C. Sections 401 et seq.); (5) an individual retirement account or individual retirement annuity within the meaning of Section 408 of the Code; (6) a retirement program consisting solely of annuity contracts or custodial accounts satisfying the requirements of Section 403(b) of the Code; (7) an eligible deferred compensation plan satisfying the requirements of Section 457 of the Code; or (8) a program maintained solely for the purpose of complying with workers' compensation laws or disability insurance laws. Reporter's Notes/Comment Paragraph (1) provides an exception for unfunded programs maintained by an employer for a select group of management or highly compensated employees. It tracks language in ERISA that exempts "top hat" plans from many of that Act's requirements. ERISA 201(2), 301(a)(3), 401(a)(1), 4021(b)(6), 29 U.S.C. 1051(2), 1081(a)(3), 1101(a)(1), 1321(b)(6) (1994). See also, 29 C.F.R (1994). The rationale for the exception is two-fold. First, a select group of management or highly compensated employees is likely to be sufficiently sophisticated and in an adequately secure position to protect its own interests, even 12

16 without the protections afforded by this Act. See, DOL ERISA Advisory Opinion 90-14A ("certain individuals, by virtue of their position or compensation level, have the ability to affect or substantially influence, through negotiation or otherwise, the design and operation of their deferred compensation plan, taking into consideration any risks attendant thereto, and, therefore, would not need the substantive rights and protections of [ERISA]"). Second, select groups by their nature are small, so the costs of compliance may well outweigh the likely benefits of coverage. Paragraph (2) clarifies that severance pay arrangements are not subject to the Act. This Act is concerned with the special problems of retirement programs that arise, in large part, because of the long-term nature and complexity of the pension promise. Severance pay arrangements, in general, are one-time payments made pursuant to a relatively simple promise. The special protections of this Act, then, are not necessary or appropriate for severance pay arrangements. The drafters of ERISA made a similar calculation in authorizing the Secretary of Labor to exempt severance pay arrangements from that Act's definition of "pension plan." ERISA 3(2)(B), 29 U.S.C. 1002(2)(B) (1994). The language of paragraph (2) is based generally on the Secretary's regulation. 29 C.F.R (b) (1994). Paragraph (3) provides an exception for supplemental retirement income arrangements that meet three requirements: 1) payments are made solely to supplement benefits of retired participants or their beneficiaries to account for increases in the cost of living since retirement; 2) the employer is not obligated to make the payments under the terms of the retirement program; and 3) payments are made out of the employer's general revenues, a separate trust fund established and maintained solely for that purpose, or a special appropriation received by the employer for that purpose. If an arrangement does not meet any one of the three requirements, the arrangement is subject to the Act. For example, if an arrangement provides for payments in excess of increases in the cost of living or the employer is obligated to make the payments under the terms of the retirement program or the payments are made out of the regular retirement trust fund, the arrangement does not qualify for this exception and the Act applies. Supplemental retirement income arrangements that meet this paragraph's requirements can take a variety of forms, ranging from modest one-time payments to significant long-term commitments. The Drafting Committee did not want to discourage employers from making supplemental payments when appropriate, nor to restrict their flexibility in doing so. At the same time, the exception is limited to ensure that the Act does apply when the arrangement begins to resemble the long-term commitment and complex promise of an ordinary retirement program. As with severance pay arrangements, ERISA authorizes the Secretary of Labor to exempt supplemental retirement income payments from ERISA's definition of "pension plan," and the Secretary has promulgated regulations to do so. ERISA 3(2)(B), 29 U.S.C. 1002(2)(B) (1994); 29 C.F.R (g) (1994). The language of this paragraph is based, in part, on the Secretary's regulation. Paragraph (4) provides an exception for arrangements with or payments made to the federal social security system on behalf of employees who are covered by social security. Public employees may be covered by social security pursuant to a coverage agreement between their State and the Commissioner of Social Security under Section 218 of the Social Security Act, 42 U.S.C. 418, or because the employees' public employer does not provide an adequate level of retirement 13

17 benefits through a retirement program. See, Service by Employees Who Are Not Members of a Public Retirement System, 26 C.F.R (b)(7)-2 (19XX). Paragraph (5) provides an exception for individual retirement accounts (IRAs). For most IRAs this is merely a clarification; most IRAs are established by individuals and, hence, would not be retirement programs within the definition of Section 1(26) because they are not established or maintained by a public employer. Some IRAs, however, are established or maintained by public employers. I.R.C. 408(c), 408(k) (1994). This paragraph means that these types of IRAs are not governed by the Act either. IRAs are excepted because they do not pose the special problems to which the protections of this Act are directed. IRAs require the involvement of other organizations (for example, banks or insurance companies) that are subject to independent sources of fiduciary obligation; they require annual reporting to the employees involved by the organizations maintaining the accounts or annuities, Treas. Reg (1980); and they are defined contribution plans that are not as complex and do not pose the same risks as defined benefit plans. For IRAs, then, most of the protections of this Act would duplicate protections elsewhere. Thus, the costs of complying with the Act, although likely to be minimal, would not be justified. For the same reasons, paragraph (6) provides an exception for annuities or custodial accounts under I.R.C. 403(b) (1994). Paragraph (7) provides an exception for deferred compensation plans under I.R.C. 457 (1994). To be an eligible deferred compensation plan under I.R.C. 457, the plan's funds must remain solely the property of the employer and be subject to the claims of the employer's general creditors until the funds are distributed to participants and beneficiaries. I.R.C. 457(b)(6). These requirements are inconsistent with the basic approach of this Act. Paragraph (8) clarifies that workers' compensation and disability insurance programs are not subject to the Act even though the programs may provide retirement income to some employees and thus fit within a strict reading of the definition of retirement program in Section 1(26). SECTION 3. ESTABLISHMENT OF TRUST. (a) Subject to subsections (b) through (d), all assets of a retirement system are held in trust. The trustee has exclusive authority, consistent with its duties under this [Act], to invest and manage those assets. (b) Assets of a retirement system which consist of insurance contracts or policies issued by an insurer, assets of an insurer, and assets of the system held by an insurer need not be held in trust. 14

18 (c) If an insurer issues a guaranteed benefit policy to a retirement system, assets of the system include the policy but not assets of the insurer. (d) If a retirement system invests in a security issued by an investment company registered under the Investment Company Act of 1940 (15 U.S.C. Sections 80a-1 et seq.), the assets of the system include the security, but not assets of the investment company. Reporter's Notes/Comment Subsection (a) states the basic principle of this section: All assets of a retirement system are held in trust. Subsections (b) through (d) provide guidance on particular applications of the principle. Subsection (b) applies the general principle to insurance contracts or policies and assets controlled by insurance companies. Insurance contracts and policies themselves need not be held in trust. This means, for example, that a system purchasing annuity contracts to provide future benefits for participants could permit those contracts to be held directly by the participants, rather than in trust by the trustee. Subsection (b) also provides that neither assets of an insurance company nor assets of a system which are held by an insurance company need be held in trust. Unless the assets fit within the narrower exception in subsection (c), however, the individuals managing the assets are subject to the fiduciary duties of Section 6. The effect of this exception in subsection (b), then, is to abrogate obligations imposed by the trust requirement only, that is, by the trust requirement but not by the fiduciary duties of this Act. In particular, the primary effect is to permit insurance companies to co-mingle retirement system assets with other assets. Subsections (c) and (d) clarify application of the Act to guaranteed benefit policies issued by an insurer and to securities issued by an investment company registered under the Investment Company Act of The basic approach for both is the same. The securities and policies themselves are "assets of the system" and, hence, subject to the Act's trust and fiduciary sections, but the underlying assets with the insurer and investment company are not "assets of the system" and, hence, are not subject to the trust and fiduciary sections. This means that decisions to invest in these types of policies or securities are fiduciary decisions and that the policies or securities themselves must be placed in trust (unless they fit within the subsection (b) exception). However, once the underlying assets are with the insurer or investment company, neither the trust nor fiduciary sections of this Act apply to decisions respecting those assets. The general principle in operation, then, is the same for both guaranteed benefit policies and investment company securities: The obligations of this Act apply to decisions to invest in these types of policies and securities, but do not flow through to decisions made by the insurance or investment company respecting the underlying assets. Although subsections (c) and (d) provide safe harbors for these two circumstances, this general principle also applies in other circumstances (for 15

19 example, to publicly offered securities held by a retirement system). Like ERISA, however, this Act does not provide a detailed listing of these circumstances or a general definition of "assets of the system." The Drafting Committee thought it inadvisable to attempt to provide a listing or definition. Applying the principle is usually quite easy, so generally a listing or definition would not be necessary or helpful. The small class of difficult cases would require a lengthy list or complex definition; that class of cases is better left to the sound discretion of trustees, within the constraints imposed by their fiduciary and disclosure obligations. The subject would be an appropriate one for rule-making. See 29 C.F.R , (1994). The basic principle of this section the requirement that assets of retirement systems be held in trust is one of the guiding principles of ERISA and is required by the Constitution in a number of States. See ERISA 403(a), 29 U.S.C. 1103(a) (1994); Cal. Const. art. XVI, 17(a); Nev. Const. art. IX, 2; Tex. Const. art. XVI, 67(a). This section generally follows Sections 403(b)(1)-(2) and 401(b)(1)-(2) of ERISA. 29 U.S.C. 1101(b)(1)-(2), 1103(b)(1)-(2) (1994). SECTION 4. POWERS OF TRUSTEE. (a) In addition to other powers conferred by the governing law, a trustee has exclusive authority, consistent with its duties under this [Act]: (1) to establish an administrative budget sufficient to perform its duties and, if necessary, to draw upon assets of the retirement system to fund the budget; (2) to obtain by [employment or] contract the services necessary to exercise its powers and perform its duties, including actuarial, auditing, custodial, investment, and legal services; and (3) to procure and dispose of the goods and property necessary to exercise its powers and perform its duties. (b) In exercising its exclusive authority under this section, a trustee is subject to the fiduciary duties of this [Act], but not to [civil service, personnel,] procurement, or similar general laws of this State relating to the subjects of subsection (a). (c) No part of this section is subject to implied repeal by a subsequent general law relating to these subjects if such construction can reasonably be avoided. 16

20 Reporter's Notes/Comment This section is intended to ensure that retirement system trustees have a level of independence sufficient to permit them to perform their duties and to do so effectively and efficiently. Trustees are different from other state actors because they are subject to an extensive and stringent set of fiduciary obligations to retirement system participants and beneficiaries. These obligations both require and justify some level of trustee independence. Independence is required because it permits trustees to perform their duties in the face of pressure from others who may not be subject to such obligations. In the absence of independence, trustees may be forced to decide between fulfilling their fiduciary obligations to participants and beneficiaries or complying with the directions of others who are responding to a more wide-ranging (and possibly conflicting) set of interests. In this sense, the independence of this section is an important corollary of the fiduciary obligations of other sections of this Act. The fiduciary obligations of trustees also justify the level of independence protected by this section. Trustees are not independent without constraint; instead, they must comply with their fiduciary obligations when exercising judgment. This section provides trustees with more independence than many other state actors, but in exercising that independence the trustees are subject to a more extensive and stringent set of fiduciary obligations than other state actors. The trustee independence protected by this section aligns well with the interests and prerogatives of the Legislature. First, the Legislature has a strong interest in effective and efficient management of public retirement systems. Mismanagement presents obvious political hazards and, in the long run, may result in lower benefits, higher contribution levels, or both. The trustee is already under a fiduciary duty to act effectively and efficiently; this section removes constraints that may interfere with the fulfillment of that duty. Second, the Legislature is interested in protecting its legitimate prerogatives. Subject to the state constitution and other law, the Legislature retains control over settlor functions; the Legislature, for example, creates retirement programs, establishes benefit levels, and determines funding methods. Cf. Haberern v. Kaupp Vascular Surgeons Ltd. Defined Benefit Plan, 24 F.3d 1491 (3d Cir. 1994), cert. denied, 115 S. Ct (1995) (employer did not violate fiduciary duties of ERISA by exercising settlor functions of setting wages, creating defined benefit plan, or amending plan); Laurence B. Wohl, Fiduciary Duties Under ERISA: A Tale of Multiple Loyalties, 20 U. Dayton L. Rev. 1, (1994) (discussing the distinction between settlor and fiduciary functions under ERISA). This section does not infringe on those prerogatives. Rather, it protects trustee independence only within the trustee's legitimate role of managing the operation, administration, and assets of a retirement system. Subsection (a)(1) authorizes the trustee to draw upon retirement system assets to fund the administrative budget, but does not require the trustee to do so. Similarly, the paragraph does not obligate, or preclude, the State from providing revenues to fund the administrative budget. Thus, if the administrative budget is currently fully funded out of general state revenues, that could continue. On the other hand, if general state revenues are insufficient to fund an adequate administrative budget, the trustee has authority to supplement the revenues with retirement system assets. 17

21 Subsection (a)(2) is intended to provide the trustee with broad authority over personnel matters. The intent is to free the trustee from restrictive civil service requirements; to shield the trustee against interference by others who do not share the trustee's fiduciary obligations; and to protect the trustee against representation by those with potentially conflicting interests. Cf., People ex Rel. Sklodowski v. Illinois, 642 N.E.2d 1180 (Ill. 1994) (state attorney general not disqualified from representing three state retirement systems as defendants in a lawsuit, while also representing the State and various state officials as defendants in the same lawsuit). The employment language is bracketed because some state constitutions may require certain retirement system employees to be within the civil service system. See, Colo. Const. art. 12, 13; La. Const. art. 10, 1. In the absence of such a constitutional restriction, however, the Drafting Committee's recommendation is to include the bracketed language in the Act. Subsection (a)(2) merely authorizes the trustee to obtain actuarial services, free from interference. The paragraph does not address the effect of determinations by the trustee's actuary, nor require that the actuary obtained by the trustee under this paragraph be the only one. Those issues are decided elsewhere in state law. Compare Dadisman v. Moore, 384 S.E.2d 816 (W. Va. 1988) (state statutes and constitution violated when legislature failed to contribute amount to state pension funds determined appropriate by trustee's actuary) with Jones v. Board of Trustees of Kentucky Retirement Systems, 910 S.W.2d 710 (Ky. 1995) (state statutes and constitution not violated when legislature failed to increase contribution rate recommended by trustee's actuary). See, N.J. Rev. Stat. 43:4B-1 (Supp. 1995) (committee designated to select an actuary for state retirement systems). Subsection (a)(3) is intended to provide the trustee with broad authority over procurement matters. The intent is to free the trustee from restrictive procurement requirements. Subsection (b) clarifies that the intent of the section is to subject the trustee to the fiduciary duties of this Act, but not to obligations imposed by general civil service, personnel, or procurement laws. The subsection also clarifies that general laws that do not relate to the subjects of subsection (a), such as conflict of interest or code of ethics rules, are not affected by the section and, hence, continue to apply to the trustee. Cynthia L. Moore, National Council on Teacher Retirement, Protecting Retirees' Money (3d ed. 1995) (citing conflict of interest and code of ethics laws applicable to trustees in most States). Subsection (c) follows U.C.C in rejecting any repeal by implication. SECTION 5. DELEGATION OF FUNCTIONS. (a) A trustee or administrator may delegate functions that a prudent trustee or administrator acting in a like capacity and familiar with such matters could 18